1031 Basics - (Part 1 of 1031 Exchange Series)

One of my major 2020 undertakings was the completion of a massive 1031 exchange. I sold three properties, then bought three new properties. This process allowed me to defer all capital gains from my sales, plus improve my cash flow by around $1,500 per month.

I completed this process in late October 2020, and now I’m ready to share some details about my experience. Because this is such a massive topic, I’ve decided to break up the talking points into separate articles and group them together as a blog series. Hopefully this will make things easier to digest for you, dear reader, and also make it easier for me to put together.

Disclaimers:

• I’m not a tax professional or an accountant; in fact, everything that I did and learned regarding the 1031 exchange involved relying heavily on the advice of trusted experts. Therefore there are some intricacies that I might oversimplify or gloss over. To document all the little nooks and crannies of the tax code would take an entire book and I just don’t have the time or expertise to cover everything.
• There’s some specific rules about other assets that do or do not apply to 1031 exchanges, and I don’t know what they are. All that matters to me is that I know you can do 1031 exchanges with investment properties.

WHAT IS A 1031 EXCHANGE?

Let’s start with the basics. As defined by Investopedia: “In real estate, a 1031 exchange is a swap of one investment property for another that allows capital gains taxes to be deferred.”

The key word to expand upon here is “swap”. While it is possibly for party A and party B to switch properties, in practice this very rarely happens. What really happens in a 1031 exchange is party A sells a property to party B, then party A uses the proceeds to buy a property from party C.

THE incentive for embarking on this complicated journey is the deferment of capital gains taxes. Depending on your circumstances, this could amount to thousands or tens of thousands in saved (deferred) taxes. It is generally believed that the IRS offers this tax incentive to encourage more transactions, and keep investors’ equity invested in the real estate market. Without this incentive, real estate owners would hold onto properties longer (or perhaps forever) to avoid having to pay a large tax bill. Or, owners might decide to sell a property and move their equity into the stock market or their bank account. With the 1031 incentive in place, this keeps more capital invested in real estate, which means higher property values and more money/effort going towards maintaining and improving properties - all positive things for society that the government wants to encourage.

1031 RULES AND GUIDELINES

As with anything involving the IRS, 1031 exchanges come with boatloads of guidelines and requirements. If you miss one criteria or deadline, you’ve basically failed to qualify as a 1031 exchange are are now forced to pay your capital gains tax. Due to the complicated and time-sensitive nature of 1031 exchanges, the enlistment of professionals is essential.

Guidelines and rules include the following:

• More than one property can be sold or acquired. You can sell one and buy three, or you can sell three and buy one, if you want.
• Size doesn’t matter, but the price does. You can sell a single family house and buy an apartment building, or vice versa. Vacant land, office buildings, bed and breakfasts, etc. can all be exchanged for each other. However, the price of all properties sold must be less than the price of all properties bought. This is why it’s referred to as “upgrading” or “trading up”.
• All funds from sold properties must NEVER touch your hands. This means a third party (termed “qualified intermediary”) must be contracted to handle all the proceeds, then direct them to the acquisition of the replacement properties. Never means NEVER. You can’t sell a property, deposit the funds for a day, then send them to the 1031 intermediary. When you sell, the funds get wired directly to the intermediary.
• Replacement properties must be formally IDENTIFIED within 45 days of closing on the relinquished property. This involves the submission of a list of properties, and even this list must meet certain requirements. (for more details, here’s a good overview)
• Replacement properties must be PURCHASED within 180 days after (and not before) closing on the relinquished property.

FACTORS TO CONSIDER

Given the benefits and the effort required to undertake a 1031 exchange, here’s some factors to consider. In some cases, it would make sense to just sell a property and deal with the tax consequences.

• If you want to sell the property, avoid capital gains AND want to grow your portfolio, 1031 exchange is the perfect tool. This effectively moves your equity (which, hopefully, has grown) from property to property and keeps it from getting eaten up by capital gains.
• If the property is a loser on your tax return (i.e. it will show as a capital LOSS instead of a gain), a 1031 exchange is pointless. Take the loss, use it to offset other gains, and move on. 
• It should be noted that even if the property is a loser on paper, it could still trigger capital gains upon sale. Basically the cost basis according to the IRS could be much lower than your actual cost basis. To put it in simple terms, you could lose money on an investment, PLUS owe the IRS capital gains tax. Pretty sweet deal for the IRS, right? ;)
• If you don’t have the time, resources, and a network to find good replacement properties, it would probably be best to just sell the property and move on. Due to the timing restrictions, you need to be in a position to find new properties and act fast. You don’t want to put yourself in a situation where you need to panic buy - this can cause you to overpay on a property just to avoid paying tax.
• You can perform multiple 1031 exchanges. For example, in theory you can buy a single family house, hold it for 10 years, then upgrade to a 4 plex. Then 10 years later you could upgrade to a 20 unit apartment building, and so on. The capital gains just keep getting deferred if you do all these upgrades via 1031 exchanges. However, you need to be careful when doing this, because if/when you sell that last property, you will get killed with a massive capital gains tax bill - ALL the gains that you deferred from every single relinquished property will be taxed. This could put you in a funky situation where you might sell that 20 unit - after you pay off your loan, and pay your capital gains tax, you might be left with nothing (or worse)! This is not a reason to NOT do a 1031 exchange, just something to be mindful of.

CONCLUSION

As you can see, 1031 exchanges are a fantastic wealth building tool but like anything this complicated, you need to be knowledgeable and prudent when using it. I can tell you from experience that it’s not that bad IF you enlist the help of the right experts and ask them tons of questions before, during, and after the process.

Coming soon - in my next 1031 series post, I’ll outline my thought process on which properties I chose to sell, why I decided to sell them, and why August 2020 was the perfect time to sell. Stay tuned!